Does Emissions Trading Produce Technological Innovation?

David Roberts from Grist has an interesting new article that strongly reminded me of the current situation in the EU emission trading system (EU ETS). Due to the recession, the EU ETS now has a substantial surplus of emission allowances. Some have calculated that companies might be able to continue with their “business as usual”, that is, no further emission reductions, until 2020.

Roberts discusses a recent scientific article on emissions trading and innovation. The article looks at the sulfur dioxide (SO2) and the nitrogen-oxides (NOx) trading programmes in the USA.

When the programs were being developed, everyone overestimated how expensive they would be (which always happens). Two things followed from that. First, politicians got scared and set emission-reduction targets too low. Second, the private sector overestimated how much technology innovation would be demanded and thus over-invested in R&D.

When the programs went into effect, regulated entities responded with “an unanticipated mix of the abatement strategies of fuel modification, combustion modification, postcombustion control, demand reduction, and generation replacement.” It turned out to be fairly cheap to comply with the low standards using existing practices and technologies; not much technological innovation was needed. As a result, “commercially oriented inventive activity declined during trading for SO2 and NOx indicator technologies” (my emphasis).

“The implication,” Taylor writes, “is that [cap-and-trade programs] do not inherently provide sustained incentives for private sector R&D investments in clean technologies, but may add to the uncertainty inherent in inventive activity.”

Now, this is certainly true, but a lot of work is being done by “inherently” and “may.” Let’s try to tease out the conclusions in more detail.

As Roberts points out, there is indeed nothing “inherent” in cap-and-trade that spurs innovation. The purpose of of the “trade” part is to minimise the costs of reducing emissions. The emission reduction is not achieved by the trading, it is achieved by capping emissions at a certain level. Innovation is spurred by high prices, and if the cap is weak, prices of emission allowances will be low.

However, weak caps are not “inherent” in emissions trading programmes. Strict caps would lead to high prices and hence more innovation.

In that sense, a cap-and-trade program obviously can spur innovation. Just implement stricter targets! The more vexing question is whether they ever do. The evidence thus far seems to indicate that cheap compliance costs are taken as victories for politicians involved, not as a sign that environmental stringency should be increased. In fact, there’s arguably not a cap-and-trade program in the world with environmentally sufficient targets. It may be that insufficient targets, while not inherent in cap-and-trade, are, as a matter of contingent fact, always part of it. (I don’t think this argument is as settled as some take it.)

The EU experience certainly supports this observation. The first trading period of the EU ETS from 2005 to 2007 also had a massive surplus, partly due to faulty baseline data and partly due to lack of political will. But the EU member states would nevertheless have gone forward with another round of weak caps for the second trading period if the European Commission had not stepped in and substantially cut the proposed allocations. And now we have another massive surplus and member states are unable to agree to cutting it.

In addition, there might be even greater surprises on the cost side than in the cases of SO2 and NOx.

If SO2 and NOx compliance were more varied and less expensive than expected, there are reasons to think CO2 compliance would be doubly so. Not only will targets inevitably be set too low (at least in the early years), but, since almost every modern industrial activity releases CO2, the number and variety of compliance strategies is almost endless. Plenty of reductions require no technological innovation at all, and plenty more “low-hanging fruit” remains to be rooted out. Allowance prices will likely be “unexpectedly” low for a good long while, especially if the carbon cap-and-trade program goes global. Thus there will be little direct incentive for innovation. (…)

If we want aggressive innovation before carbon prices reach $100 a ton, we need to make it happen ourselves, on purpose, with focused innovation policy.

Focused innovation policy has another benefit, related to political economy. Taylor refers to it obliquely in the press release: “policymakers also seldom set targets they don’t have evidence that industry can meet.” Until they can see the technologies that will be used for compliance, politicians don’t feel safe setting stringent targets. Even if, in reality, compliance will mostly be achieved through other channels, it is politically helpful to have whizbang technologies at hand.

What Taylor’s paper really shows — what we all should have agreed on by now anyway — is that both carbon pricing and innovation policy are needed. They are not at odds. Especially in the early decades, they accomplish different things, in terms of emissions, economics, and political economy. The fact that rival camps are arguing with each other over this, while nothing is actually happening on either front, is a special kind of stupid.

This point is also excellently argued in another recent article I’m going to cover in a future post.